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Financial Repression Dogs China

This article appeared in the Australian Financial Review on October 3, 2006.

Since the start of the reform movement in late 1978, China’s leaders have declared that their top priority should be to achieve robust economic growth and improve the standard of living. They chose this path of ”peaceful development” to minimise the likelihood of civil and economic unrest that dominated the Mao regime. China’s accession to the World Trade Organisation in December 2001 was evidence of the commitment to liberalise trade and the financial sector.

Progress has been made since 2001, but much remains to be done. It is clear that opening capital markets without reforming state-owned banks and without maintaining monetary stability could lead to substantial capital flight and exacerbate the problem of non-performing loans. Moreover, there must be an effective legal system to protect newly acquired private property rights.

If Beijing chooses to keep the yuan, also known as the renminbi (RMB), undervalued and maintains capital controls, China will continue to experience stop-go monetary policy as the domestic money supply responds to the balance of payments and the People’s Bank of China tries to sterilise capital inflows—that is, withdraw excess base money.

The State Council announced earlier this year that it wanted to achieve an external balance in 2006, but China’s overall trade surplus will match or exceed last year’s historic high of $US102 billion. Likewise, the PBC constantly says its goal is to pursue a ”sound monetary policy” and ”keep the RMB exchange rate basically stable at an adaptive and equilibrium level”. Yet, money and credit continue to grow at rates inconsistent with long-run price stability, and the exchange rate is still pegged at a disequilibrium level.

In a May 23, 2006 press release, the PBC recommended ”better coordination among the various macro-policies, transformation of government functions, and institutional innovation”. It also promised that the ”foreign exchange system reform will be deepened”, and committed itself to ”preserve the continuity and stability of monetary policy, and promote appropriate growth of money and credit, in order to provide a stable monetary and financial environment for economic restructuring”.

Those objectives are laudable, but the rhetoric has failed to match the reality. In its monetary policy report for 2003, the PBC said it would maintain the yuan exchange rate ”at an adaptive and equilibrium level”. Yet, the yuan/dollar rate remained fixed at 8.28 from 1994 until July 21, 2005, when it was revalued by 2.1 per cent, and has only appreciated slightly since then to about 7.98 yuan.

As a result, China’s foreign exchange reserves have more than doubled since 2003. Clearly, financial repression is the hallmark of China’s state-directed financial regime. If China is to carry out its plans for financial liberalisation and have a flexible exchange rate regime, the PBC must have greater independence.